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ESG factors in tax? That’s a yes

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As Environmental, social and governance (ESG) concerns’ feature ever more prominently in shareholders’ decision-making, the scope of their application is simultaneously expanding. Put simply, companies and organisations must expect that an ever-wider array of their actions will be judged on whether they’re responsible as well as profitable. Tax policies and structures ought be re-examined in this light.

Today, we are seeing a trend towards increasing voluntary transparency through such examples as early engagement with revenue authorities such as the Australian Taxation Office, best practice internal tax policies and increasing international information sharing. What does this all mean and what impact does it have on your business? We believe that businesses both large and small should be thinking about their stance towards formal, informal and more intangible ESG factors as they relate to tax.

In this piece we breakdown [or try to grasp] what ESG as a concept is, in a taxation context, what external and internal factors businesses need to consider and share six ideas on what we think businesses should be starting to think about.

A wide field of inquiry

ESG in a tax context concerns companies doing the “right”, "responsible” and/or “fair” thing with regard to their taxes. 

Grasping ESG as a concept is not without difficulty, particularly in a taxation context.

Academic literature on the topic frequently refers to a company paying its “fair share” of tax, for example, but what constitutes “fair”, “right” or “responsible” is a matter of significant controversy and judgment.  Such views often differ wildly over time, between companies in the same industry, officers within the same company, political parties and indeed countries. Certain types of aggressive tax avoidance strategies may be clearly inconsistent with good governance, but many options are open to companies in structuring their tax affairs that are less obviously “aggressive”. Which of those options are consistent with a company paying their “fair share” can be difficult to work out, especially when there are competing pressures at play.

Tax-related ESG concepts can roughly be split into two elements: internal (or private) and external (or more public-facing). Internal aspects may include a company’s written taxation policies, which may cover the company’s procedures in relation to tax and compliance risk, the use (or non-use) of “aggressive” structures and the levels of justification required towards the tax positions it takes, and its cultural attitude towards engagement with revenue authorities globally. External factors may include participation in early engagement and audit procedures with revenue authorities, voluntary disclosures of tax positions taken, and, in an Australian context, voluntary public disclosure of a company’s tax payments and strategy under the Voluntary Tax Transparency Code (“VTTC”).

It is up to each company to determine its ESG position, having regard to their shareholders’ directions and tolerances. Questions which should be asked in determining where each company lands on the issue include:

  1. What guidance or restrictions should there be on a company’s tax affairs beyond the bounds of the written law itself?
  2. How much primacy should ESG considerations take over structures permitted by the law?
  3. What room is there for differing interpretations of tax laws?

Other considerations which complicate ESG include the complexity of many businesses’ tax affairs, commercial sensitivities and privacy concerns. Given the increasing public pressure on revenue authorities to publicly disclose companies’ tax information, is it better for those companies to voluntarily disclose that information themselves?

These issues must be considered not just once, but on an ongoing basis within a specific organisation’s context.

Decisions relating to tax (both directly and indirectly) are ultimately made by individuals. A written tax policy is a good start in guiding such decisions, but ESG does not end there. If a company is to take ESG seriously as part of its tax affairs, the person “holding the pencil” needs to be provided with clear, useful guidance about how the tax ESG policy translates into practice for that company and for the individuals that represent the company, and the company needs to foster a culture amongst its people, both within and outside its tax personnel, which places importance on transparency and compliance as outlined in the policy.

External/public factors

As noted earlier, ESG concepts relating to tax can be roughly divided into internal and external factors. Key public-facing elements of ESG in the Australian context include the Voluntary Tax Transparency Code and the ATO’s annual Report of Tax Entity Information.

Voluntary Tax Transparency Code

In February 2016, the Board of Taxation released its “A Tax Transparency Code” report. The VTTC is intended to be a set of principles and standards to guide the disclosure of tax information by large (AUD 500m+ turnover) and medium-sized (AUD 100m to AUD 500m turnover) businesses. The code is entirely voluntary and disclosure is not enforced, though misleading disclosures may be penalised under other laws.

Materials disclosed under the VTTC are intended to be used by “general users” (the community at large), “interested users” (shareholders, investors, media etc) and by revenue authorities.

The Board of Taxation suggests disclosure of the following information:

Large and medium businesses
  • Reconciliation of accounting profit to tax paid
  • Identification of material temporary and non-temporary differences
  • Accounting effective company tax rates for Australian and global operations in accordance with accounting standards
Large businesses only
  • Approach to tax strategy and governance
  • Tax contribution summary for corporate taxes paid
  • Information about international related party dealings

As a voluntary code, there is not much guidance about how such information should be set out and how much detail should be provided. A review of various companies’ recent voluntary disclosures under the VTTC revealed little commonality between them. Some taxpayers provided detailed documents which explained how their tax strategy was aligned with their core values, while others took a “minimum required” approach.

A key issue with voluntary transparency is explaining complex tax issues for the various users of that information. Banks and other financial institutions typically did a reasonable job of breaking down complex taxation concepts into plain English, while other entities provided a dense report which had a high level of assumed knowledge. Our review also evidenced tax disclosures both as a standalone document and alternatively as part of a broader ESG report.

The examples generally did not discuss their entities’ offshore operations, or taxes other than corporate income tax.

Overall, our key observation on the VTTC is that a company’s response will likely evolve over time, incorporating changing governance practices and social expectations, the legal and commercial environment, and developments in global tax transparency initiatives. It may become increasingly necessary to “voluntarily” comply over time as part of accepted business practices and as a requirement for engagement with government and other businesses.

Report of Tax Entity Information

Separately, the ATO annually publishes the Report of Tax Entity Information, which discloses the total income, taxable income and income tax payable of entities with a total annual income of AUD$100m+. This is a very blunt measure of tax contributions, providing far less information to the public than the VTTC, but it is wholly outside the control of companies.

The key, for those companies whose data is published, is to ensure that it can adequately explain its tax position.  Whilst the ATO website provides a brief summary of what might affect a company’s tax position (for example, cyclical economic cycles, significant deductible infrastructure investment prior to the derivation of income etc), companies should be prepared to explain its specific circumstances within the context of their broader tax ESG policies.

Internal/private factors

Tax policies

Tax policies differ between each organisation, depending on their size, structure, activities and attitude towards risk. Not every organisation has such a policy, and the existence of a policy alone will do nothing without the understanding and support of the organisation’s decision-makers – in other words, the policy must be lived and breathed, and not merely put on a shelf.  Nevertheless, the existence of a tax policy is one of the first positive steps in implementing broader tax ESG awareness within an organisation.

We see a number of common factors between tax policies. They typically include:

  • general approach to taxation risk, with specific commentary around relevant issues such as transfer pricing and the use of offshore structures;
  • the company’s attitude towards tax compliance, transparency, audits and settlements, including its relationship with revenue authorities;
  • the resources which are to be used in preparing tax work; and
  • an outline of the organisation of the tax function and who is responsible for tax matters.

More sophisticated tax policies go beyond income taxes to other taxes such as consumption taxes and bespoke taxes like resource rent taxes, withholding taxes and state taxes. Entities relying on information provided by outsourced service providers such as custodians and administrators may also have policies covering the assessment of third-party data which feeds into their tax reporting obligations, such that they might minimise the risk of inaccuracies (the ATO’s guidance for “governance over third-party data” can be found here).

Engagement with the ATO

Since around 2015, the ATO has operated in a framework of “justified trust”.  A concept put forward by the OECD in 2013, it involves the ATO asking, if we told the community how we assured the tax paid by a taxpayer, would they be satisfied we did enough?

Justified trust involves a review of the taxpayer’s tax risk management and governance framework, identifying tax risks, understanding new and significant transactions, and getting a holistic understanding of a taxpayer’s business operations and financial performance to understand their accounting and tax results.  The company’s risk profile established by the ATO in this process determines the level of scrutiny that the ATO will impose on a company.  As such, while ESG in a tax context is still developing as a concept, it has a direct and immediate bearing on a company’s interactions with the ATO.

A taxpayer can choose to be more or less compliant during “justified trust” and other interactions with the ATO, though an unwillingness to be transparent and forthcoming at early stages, or an inability to produce a considered tax framework and policy, can result in more intensive reviews being taken later.

The ATO’s review processes are presently aimed at large taxpayers, but the process is expanding (from the Top 100, to the Top 500, to the Top 1,000 and to the Next 5,000 taxpayers).  As the ATO’s net widens, it is not surprising that ultimately, all companies will be asked to provide details of their tax policies and broader tax ESG positions.  It therefore pays to be prepared now.

What should I be doing?

ESG in a taxation context is becoming become more prevalent and is weighing more heavily on stakeholders including shareholders, regulators, politicians, employees, customers and the general public. Taxation issues regularly make headlines and the international trend towards governmental information-sharing, anti-abuse rules and minimum tax rates will make risky tax positions increasingly difficult to justify.

In that context, it is worth well-worth thinking about the following:

  • Does my organisation have a taxation policy and framework? What does it say? Does it need to be updated or expanded?
  • What is my organisation’s tolerance for tax risk? What level of justification for tax positions is necessary? Is this consistent with my shareholders’ expectations?
  • Who makes the decisions in my organisation about its tax affairs? Who might make decisions which affect tax, but is not part of our tax personnel?
  • Are our tax personnel adequately heard in decision-making processes? Are tax compliance considerations given adequate weight?
  • What are our current obligations to disclose information to the ATO and other regulators? Do we want to go beyond what we are obliged to do and voluntarily disclose more?
  • Do we have any “high risk” structures in our organisation (and what do we consider to be “high risk”)? Do they need to be addressed?
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